K, 

t;^65 


THE  VALUATION  OF  PUBLIC   UTILITIES 
WITH  SPECUL  REFERENCE   TO 
GAS  AND  ELECTRIC   PROPERTIES 

by 

PAUL  THELEN 


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UNIVERSITY  OF  CALIFORNIA 
AT  LOS  ANGELES 


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}unoui04}!-| 


THE  VALUATION  OF  PUBLIC 
UTILITIES 

WITH   SPECIAL  REFERENCE  TO 
GAS  AND  ELECTRIC  PROPERTIES 


BY 
PAUL  THELEN 

Assistant  Engineer,  California  Railroad  Commission 


UNIVERSITY  OF  CALIFORNIA  PRESS 

BERKELEY 

1916 


THE  VALUATION  OF  PUBLIC  UTILITIES* 


SYLLABUS 

Introduction — purpose  and  seoiie  of  paper. 

Purpose  of  Valuation: 
(a)   Transfer. 
(&)   Taxation, 
(e)   Eates. 
((Z)   Issuance  of  securities. 

Reasons  why  purpose  must  clearly  be  kept  in  mind. 

Valuation  report  proper  involves: 

(a)  Inventory: 

(1)  Tangible  Capital. 

(2)  Intangible  Capital. 

(Classifications  of  Accounts  for  Fixed  Capital). 

(b)  Unit  Prices  for  cost  to  reproduce,  etc. 

(c)  Original  Cost: 

(1)  Non-operative  propertj'. 

(2)  Expenditures  unwisely  made. 

(3)  Expenditures  involving  collusion. 
(f?)    Cost  to  Reproduce: 

(1)  At  present  day  prices. 

(2)  Actual  performance  method. 

(3)  Historical  Cost. 

(e)   Cost  to  Reproduce  Less  Depreciation: 

(1)  Straight  Line  Method. 

(2)  Sinking  Fund  Method. 

(/")    Contingencies,  errors  and  omissions. 
(^)   Working  Capital. 
(K)   Development  Cost. 

Application  of  results: 

(a)  Transfer. 

(b)  Taxation. 

(c)  Rates. 

(d)  Issuance  of  Securities. 

Conclusion. 


*  Address  to  be  delivered  before  Engineering  Students.  University  of 
California,  Apr.  6,  1916,  under  the  auspices  of  the  Gas  Engineering 
Department.  ,^ 


rW*i 


Tliis  [(apcr  will  cover  in  a  ^^cin'ial  way  the  siihjcct  of  Utility  Valua- 
tions, their  purpose,  scope  ami  aj)i)lication.  Although  the  audience  before 
whom  this  paper  is  presented  consists  of  students  in  an  engineering  class 
who  are  primarily  interested  in  gas  and  electric  utilities,  nevertheless 
the  subject  of  valuation  of  these  utilities  is  but  a  portion  of  a  larger 
field;  and  a  discussion  which  covers  this  larger  field  will  perhaps  be  of 
more  interest  to  prospective  gas  and  electric  engineers  than  a  discussion 
which  confines  itself  entirely  to  the  details  involved  in  the  valuation  of 
a  gas  or  electric  utility.  The  general  j)rincijiles  involved  in  the  valuation 
of  all  utilities  are  much  the  same.  The  subject  of  Utility  Valuations  is  a 
broad  one,  and  will  have  to  be  covered  in  a  very  general  way  in  order  to 
come  within  the  time  limits  which  are  prescribed. 

The  purposes  for  which  a  valution  may  be  made  are  many,  yet  most 
valuations  are  prepared  in  connection  with  one  of  the  following  classes 
of  proceeding: 

(a)  Transfer. 
(6)   Taxation. 

(c)  Eates. 

(d)  Issuance  of  Securities. 

It  will  be  well  to  state  at  the  outset  that  the  use  which  is  to  be  made 
of  a  valuation  must  be  clearly  kept  in  mind  in  preparing  any  statement 
of  total  values  or  costs.  Thus  a  valuation  which  is  prepared  for  the  pur- 
pose of  taxation  will  include  property  which  would  be  classed  as  non- 
operative  and  therefore  be  excluded  if  the  valution  were  to  be  made  for 
the  purpose  of  rate  fixing.  A  valution  made  for  the  purpose  of  transfer 
must,  of  course,  include  in  its  inventory  only  such  property  as  is  con- 
templated by  the  transfer.  A  valution  for  issuance  of  securities  must 
involve  such  property  as  will  be  hypothecated  in  the  case  of  a  mortgage 
or  yield  income  in  the  case  of  issuance  of  stock.  We  could  multiply  such 
illustrations  readily. 

If  we  follow  the  progress  of  the  science  of  valuation  engineering  from 
its  earlier  days,  we  find  that  the  first  valutions  were  made  almost  entirely 
in  connection  with  transfer  of  property.  Here  the  valuation  report  itself 
was  originally  not  a  matter  of  great  moment  because  it  was  the  earning 
capacity  rather  than  physical  properties  which  had  most  bearing  on 
value.  It  was  largely  a  valuation  to  determine  the  depreciated  cost  to 
reproduce,  sometimes  loosely  termed  "present  value." 

Valuation  engineering  has  but  rarely  been  called  upon  to  be  of  much 
assistance  in  connection  with  taxation  matters.  Such  valuation  statistics 
as  have  been  compiled  for  this  purpose  have  usually  been  very  crude  and 
the  present  tendency  is  to  compute  the  tax  on-  the  basis  of  gross  income 


rather  than  on  the  basis  of  invested  cost  or  cost  to  reproduce  or  depre- 
ciated cost  to  reproduce.  It  is  true  that  the  tax  which  is  computed  as  a 
function  of  gross  income  purports  generally  to  result  in  the  same  total 
amount  of  money  as  the  tax  computed  as  a  function  of  the  property  value 
in  order  that  there  may  be  no  discrimination  between  taxation  of  public 
utility  properties  and  taxation  of  the  property  of  the  private  individual. 
In  the  good  old  swashbuckling  days  a  utility  had  very  little  need  for  the 
services  of  a  valuation  engineer.  If  the  property  were  to  be  sold,  the 
valuation,  as  far  as  inventory  and  appraisal  went,  was  a  matter  of  sec- 
ondary importance.  If  the  property  were  to  be  taxed,  the  utility  had 
little  interest  in  obtaining  a  complete  inventory  and  making  a  complete 
and  all-inclusive  cost  statement.  But  these  days  are  definitely  gone. 
The  voice  of  the  people  has  spoken  in  no  uncertain  terms,  demanding  fair 
play  for  the  consumer,  publicity  of  accounts,  regulation  of  rates, 
service  and  issuance  of  securities,  the  elimination  of  discriminatory 
practices,  etc.,  etc.  The  execution  of  the  terms  of  the  resulting  legislation 
has  been  placed  in  the  hands  of  Public  Utility  Commissions  with  such 
gratifying  results  that  these  regulating  bodies  have  grown  more  and 
more  in  public  esteem  and  in  the  scope  of  their  activities  until  at  present 
there  are  very  few  public  utilities  in  the  United  States  which  are  not 
subject  to  some  form  of  supervision  or  regulation.  Where  this  super- 
vision is  of  rates  or  issuance  of  securities,  the  utility  at  once  becomes 
interested  in  a  most  complete  and  comprehensive  inventory  and  the  prov- 
ing of  every  jtossible  sort  of  value;  in  short,'  the  valuation  engineer 
becomes  a  very  respectable  gentleman. 

The  work  of  the  State  Commissions,  where  it  calls  for  the  services  of 
a  valuation  engineer,  has  been  mainly  in  connection  with  rates.  The 
issuance  of  securities  comes  next  in  order  of  importance;  transfer  of 
property  is  involved  mainly  in  condemnation  proceedings  or  actions 
brought  for  acquisition  on  behalf  of  an  incorporated  public;  while  tax- 
ation is  a  matter  over  which  but  few  Public  Utility  Commissions  now 
have  any  jurisdiction  and  it  is  probably  true  that  these  Commissions 
would  gladly  be  relieved  of  the  burden  of  this  kind  of  work  which  very 
soon  becomes  monotonous  and  always  involves  a  vast  amount  of  detail. 

The  valuation  report  proper  as  involved  in  the  work  of  the  regulating 
body  of  the  present  day  consists  of  an  inventory,  unit  prices  for  each 
item  in  this  inventory,  and  a  statement  of  original  cost,  cost  to  repro- 
duce and  cost  to  reproduce  less  depreciation.  To  this  completed  unit  of 
the  work  are  added  allowances  for  contingencies,  errors  and  omissions  to 
obtain  a  complete  statement  of  what  is  termed  "plant  investment,"  to 
which  in  turn  there  must  be  added,  for  most  purposes,  working  capital 
and,  either  by  the  engineer  or  the  auditor,  a  statement  of  development 
cost. 


The  iuvcutory  cuiisists  of  a  tabulatiuii,  in  proper  groups,  of  all  the  prop- 
erty which  is  involved  in  the  valuation  proceedings.  It  is  almost  always 
advisable,  in  preparing  an  inventory,  to  follow  the  uniform  classification 
of  accounts  pertinent  to  the  utility  under  consideration.  These  classi- 
fications of  accounts  have  been  issued  from  time  to  time  by  the  Inter- 
state Commerce  Commission  at  Washington,  D.  C,  for  those  utilities 
which  are  concerned  in  interstate  commerce  such  as  steam  roads,  electric 
railways  and  telephone  companies.  The  State  Commissions  have  wisely 
adopted  these  classifications  word  for  word  for  their  standard,  and  have 
usually  prepared  additional  classifications  for  such  utilities  as  are  sub- 
jected to  regulation  and  engaged  in  business  which  is  not  classed  as  inter- 
state commerce.  Thus  our  own  California  State  Commission  has  issued 
uniform  classifications  of  accounts  for  water  corporations,  gas  corpora- 
tions, electric  corporations  and  telephone  companies,  of  which  the  last  is 
practically  identical  with  the  classification  prepared  by  the  Interstate 
Commerce  Commission.  Our  Commission  further  uses  the  Interstate  Com- 
merce Commission's  Classifications  for  steam  roads  and  electric  railways. 

Turning  now  to  this  classification  for  gas  corporations,  of  which  a 
dozen  copies  will  be  available  for  consultation  in  Professor  Cory's  ofiice, 
we  find  that  it  concerns  itself  first  with  asset  accounts  and  liability  ac- 
counts. Of  these,  the  former  includes  the  fixed  capital  accounts  in  which 
we  are  particularly  interested  in  preparing  an  inventory  of  plant,  and  the 
material  and  supplies  accounts  in  which  we  are  interested  as  a  part  of 
working  capital.  Then  there  is  an  income  account  and  a  surplus  account, 
of  which  the  former  includes  operating  revenue  and  operating  expenses. 
We  will  be  interested  later  on  in  operating  expense  in  case  we  desire  to 
make  an  analysis  of  actual  performance  in  connection  with  such  over- 
head expenditures  as  law,  injuries  and  damages,  insurance,  general  ofiice 
expenses,  etc.,  all  of  which  occur  not  only  under  conditions  of  operation, 
but  also  during  the  days  of  construction  and  must  therefore  be  considered 
in  the  valuation  report. 

Turning  now  to  the  fixed  capital  accounts,  we  see  that  they  are  divided 
into  intangible  capital  and  tangible  capital  of  which  the  former  includes 
four,  secondary  sub-divisions  and  the  latter  five  primary  divisions,  which, 
are  again  sub-divided  so  as  to  show  a  total  of  thirty-six  secondary  divi- 
sions. It  is  this  classification  which  must  be  followed  faithfully  and  con- 
scientiously, if  confusion  is  to  be  avoided.  If  it  is  strictly  followed,  it 
becomes  a  very  easy  matter  to  locate  in  a  valuation  report  any  particu- 
lar inventory  item  which  may  be  under  discussion.  Thus  if  the  utility 
insists,  after  the  valuation  report  is  completed,  that  certain  gas  regula- 
tors temporarily  in  stock  in  the  store  room  have  been  omitted,  it  is  only 
necessary  to  turn  to  this  classification  and  note  that  gas  regulators  are 
chargeable  to  Account  C-25,  though  if  they  were  in  the  store  room  as  of 


the  (late  of  the  valuation,  it  would  be  reasonable  to  follow  the  clue  that 
if  they  were  not  listed  under  Account  C-25  they  would  be  found  under 
Stores  and  Supplies,  which  is  an  asset  account  and  is  included  in  the 
statement  of  working  capital  which  usually  follows  the  completed  state- 
ment of  plant  accounts. 

The  five  primary  sub-divisions  into  which  the  tangible  capital  is 
divided  are: 

(fl)   Landed  capital. 
(&)   Production  capital. 

(c)  Transmission  capital. 

(d)  Distribution  ea]3ital. 

(e)  General  capital. 

The  property  chargeable  to  the  thirtj'-six  secondary  accounts  under 
these  five  primary  accounts  is  largely  subject  to  count  in  the  field,  though 
there  must  alw^ays  be  a  general  identification  of  the  inventory  from  the 
office,  in  order  that  the  work  in  the  field  should  include  all  the  properties 
of  the  utility  and  should  not  include  properties  belonging  to  others.  Thus 
the  identification  of  the  inventory  from  the  office  might  state  with  re- 
spect to  production  capital  that  certain  blocks  of  land  were  owned  by  the 
company  and  that  all  of  the  holders,  generators,  buildings,  fences  and 
piping  included  in  the  lay-out  belonged  to  the  utility.  It  might  be  perti- 
nent to  remark  here  that  in  the  case  of  a  utility  which  has  come  into 
existence  since  uniform  classification  of  accounts  have  been  as  satisfac- 
tory as  they  are  at  the  present  date,  an  inventory  can  frequently  be 
worked  out  entirely  from  office  records.  An  engineer  of  experience,  how- 
ever, can  never  conscientiously  recognize  such  an  inventory  as  having  the 
same  weight  or  accuracy  as  one  which  is  based  on  the  field  inspection. 

This  sub-division  of  tangible  capital  into  five  groups  makes  it  pos- 
sible for  the  valuation  engineer  to  distribute  the  work  among  responsible 
assistant  engineers  each  one  of  whom  may  be  familiar  with  one  certain 
class  of  property,  and  not  necessarily  with  any  other  class.  Thus  it  is 
usually  good  practice  to  have  the  Landed  Capital,  Account  C-5,  Land  de- 
voted to  Gas  Operations,  handled  by  an  assistant  engineer  who  devotes  his 
entire  time  to  lands,  rights-of-way,  etc.  Similarly  the  building  accounts 
seem  to  constitute  a  group  by  themselves;  also  the  so-called  "overhead 
expenditures,"  which  are  shown  under  Account  C-35  and  labeled  "Un- 
distributed Construction  Expenditures,"  usually  require  the  personal  at- 
tention of  the  engineer  who  is  responsible  for  the  entire  valuation.  These 
so-called  overheads  include  allowances  for  engineering,  supervision,  law, 
injuries,  taxes  and  miscellaneous  expenses,  and  are  based  largely  upon 
judgment  and  experience,  and  it  is  but  seldom  that  a  satisfactory  actual 
performance  in  a  particular  ease  is  available  for  fixing  the  amount   of 


6 

these  arhitiary  percentages.  The  jnoperty  whicli  is  listed  under  I'ro- 
duction  Capital,  Transmission  Capital  and  Distribution  Capital  may  usu- 
ally to  advantage  be  left  to  a  man  who  is  familiar  with  construction  and 
operation  of  gas  utility  properties.  If  this  work  needs  to  be  further  sub- 
divided as  a  matter  of  expedition,  the  responsibility  for  Production  Capi- 
tal can  be  given  to  an  engineer  who  is  familiar  with  machinery  and  its 
installation,  while  the  mains  which  are  involved  in  Transmission  and  Dis 
trinution  Capital  can  be  assigned  to  an  engineer  whose  experience  with 
hydraulic  pipe  lines  has  rendered  him  competent  to  discuss  trenching, 
pipe  laying,  backfill,  settling,  replacing  paving,  etc. 

After  the  inventory  of  such  tangible  property  as  can  be  found  in  the 
field  is  completed  it  becomes  necessary  to  apply  a  unit  price  to  each  item 
in  the  inventory.  In  obtaining  such  unit  prices  for  the  column  of  Cost  to 
Eeproduce,  the  engineer  is  guided  largely  by  whichever  theory  he  is  fol- 
lowing in  establishing  the  column  of  figures  representing  Cost  to  Eepro- 
duce. Inasmuch  as  these  theories  w'ill  be  discussed  later  on  under  the 
topic  "Cost  to  Eeproduce,"  the  subject  need  not  be  pursued  further  here. 

We  have  said  nothing  so  far  about  unit  prices  for  the  column  of 
original  cost.  This  is  because  figures  would  usually  be  derived  figures, 
obtained  by  segregating  the  total  expenditure  actually  incurred  on  a 
given  piece  of  work  among  the  inventory  units,  and  then  applying  the 
unit  prices  thus  obtained  back  again  as  a  matter  of  multiplication  to 
reach  the  total  which  is  the  original  cost,  and  which  was  accepted  as 
being  correct.  Consequently  unit  prices  are  rarely  shown  in  connection 
with  the  column  of  total  original  cost,  though  the  unit  prices  used  in 
connection  with  the  cost  to  reproduce  are  frequently  obtained  from  an 
examination  of  original  cost  records.  Since  the  figures  of  depreciated  cost 
to  reproduce  are  obtained  as  a  percent  of  cost  to  reproduce  it  is  not  cus- 
tomary to  work  out  unit  prices  for  this  column. 

Leaving  unit  costs  now,  we  come  to  the  three  columns  of  total  cost, 
which  are  as  follows: 

1.  Original  Cost. 

2.  Cost  to  Eeproduce. 

3.  Cost  to  Eeproduce  Less  Depreciation. 

Under  Original  Cost,  it  is  usual  to  show  actual  expenditures,  as  taken 
from  the  books,  after  they  have  been  carefully  scrutinized  to  see  that 
none  of  these  expenditures  include  collusion.  Also  in  connection  with 
the  work  on  the  inventory  items  certain  non-operative  properties  may  be 
found  and  there  may  occur  expenditures  unwisely  made.  The  non- 
operative  property  must  be  eliminated  in  a  rate  case,  though  not  in  a 
taxation  matter  and  may  frequently  be  included  in  the  issuance  of  securi- 
ties and  may  or  may  not  be  included  in  ease  of  transfer.     It  is  a  rare 


matter  nowadays  to  unearth  evidences  of  collusion  tliough  it  would  be 
entirely  easy  to  give  specific  instances.  The  ancient  and  most  used  de- 
vice of  allowing  the  grading  on  the  railroad  to  be  done  at  exorbitant 
prices  by  an  independent  organization  whose  officers  are  also  the  officers 
of  the  railroad  company  has  l)een  used  once  or  twice  in  this  state  within 
the  last  decade  under  conditions  that  resulted  in  an  original  cost  to  the 
company  very  much  in  excess  of  a  legitimate  cost  to  reproduce.  Similarly 
a  mechanical  engineer  has  occasionally  received  small  private  commis- 
sions or  bribes  in  connection  with  the  purchase  of  rolling  stock  or  shop 
machinery,  and  many  small  irregularities  can  be  unearthed  in  the  office 
of  the  purchasing  agent;  however,  it  may  be  said  that  the  valuation  en- 
gineer but  rarely  unearths  any  expenditures  involving  considerable 
amount  of  dishonesty.  An  entirely  different  matter  is  presented  in  case 
a  utility  purchases  a  small  plant  to  be  included  in  its  own  larger  plant, 
and  pays  for  this  small  plant  some  amount  of  money  or  securities  which 
exceeds  the  cost  to  reproduce  of  the  elements  constituting  the  plant.  The 
gas  utility  may  under  the  classification  charge  the  entire  cost  to  Account 
C-37,  Plant  Purchased  in  Lieu  of  Plant  Constructed.  However,  the  cer- 
tainty that  valuation  proceedings  will  be  had  at  some  time  in  the  near 
future  frequently  causes  the  utility  to  distribute  this  "cost  of  plant  pur- 
chased" among  the  thirty-six  accounts  preceding.  The  utility  will  quite 
generally  attempt  to  make  such  distribution  in  an  honest  manner  and  finds 
that  it  has  paid  in  excess  of  the  sum  of  such  amounts  as  can  properly  be 
distributed  to  the  tangible  capital  accounts.  There  is  left  something  like 
10  per  cent  to  25  per  cent  of  the  purchase  price,  which  has  to  be  shown  on 
the  books  somewhere  as  having  been  expended  and  it  is  customary  to 
show  this  under  Account  C-2,  Franchises,  or  one  of  the  other  intangible 
accounts.  When  the  valuation  engineer  finds  this  condition  in  original 
cost  he  uses  his  discretion.  He  may  include  or  not  include  this  charge  in 
his  column  of  original  cost,  but  in  any  event  he  states  the  facts  in  detail 
so  that  the  regulating  body  to  which  he  reports  may  have  the  facts  at 
its  disposal  and  make  such  use  of  them  as  the  particular  proceeding  may 
demand. 

Coming  now  to  the  column  of  Cost  to  Eeproduce,  it  is  seldom  that  the 
engineer  has  specific  instructions  as  to  the  conditions  under  which  he  is 
to  reproduce  the  plant.  He  may  reproduce  an  electric  railway  system  or 
a  gas  utility  piecemeal  in  the  order  in  which  it  was  originally  constructed, 
thereby  increasing  the  unit  costs  over  what  they  would  be  if  the  entire 
plant  were  considered  as  a  unit.  To  offset  this  he  obtains  an  "Interest 
during  Construction"  considerably  less  by  the  piecemeal  method  than  it 
would  otherwise  be.  Also  he  must  decide  whether  he  will  reproduce  at 
present  day  prices  or  according  to  the  actual  price  which  the  utility  paid, 
or  whether  he  will  cover  the  entire  life  of  the  utility  and  get  a  weighted 


8 

average  of  all  expenditures,  iu  which  case  he  obtains  what  is  called  a 
historical  cost  which  should  then  be  reconcilable  in  a  very  satisfactory  man- 
ner with  the  adjusted  orifjinal  cost  of  the  books.  Inasmuch  as  the  work  of  all 
the  regulating  bodies  is  subjected  in  some  degree  to  review  by  the  courts 
we  must  primarily  look  for  help  and  guidance  to  the  decisions  of  the 
Court.  ]f  we  seek  here,  however,  for  a  statement  as  to  whether  present 
day  prices  mean  the  quotation  of  the  hour,  which  would  probably  be  un- 
reasonable, or  the  quotations  of  the  last  twelve  months,  or  three  years,  or 
five  years,  or  the  quotations  of  the  last  several  years  projected  into  the 
future,  we  find  very  little  assistance.  For  purposes  of  transfer,  it  seems 
that  the  present  day  prices  should  be  given  considerable  weight.  For 
purposes  of  rates  it  seems  that  the  historical  cost,  in  so  far  as  it  parallels 
investment  or  sacrifice,  should  be  given  most  weight  except  perhaps  in 
the  case  of  lands.  Between  these  two  methods  stands  what  has  been 
termed  by  Mr.  James  T.  Shaw  of  the  Pacific  Telepihone  and  Telegraph 
Company  in  his  argument  in  Application  1870  before  the  California  Com- 
mission as  the  "actual  performance"  method.  This  method  involves  a 
careful  scrutiny  of  the  actual  expenditures  of  the  last  three  years  or 
five  years  and  the  application  of  these  unit  costs  to  all  items  of  property. 
We  will  not  here  enter  into  a  discussion  of  the  merits  of  the  various 
possible  costs  to  reproduce,  but  will  pass  on  to  the  last  column  "Cost  to 
Eeproduce  Less  Depreciation. ' '  In  the  earlier  days  of  valuation  engineer- 
ing the  distinction  between  the  terms  "cost"  and  "value"  was  not  as 
clearly  recognized  as  it  is  today  and  this  third  column  was  quite  generally 
labeled  "present  value,"  The  term  was  so  very  misleading  that  in  spite 
of  its  brevity,  it  has  quite  generally  been  rejilaced  by  the  term  "Cost  to 
Reproduce  Less  Depreciation."  However,  inasmuch  as  there  are  many 
diiferent  methods  of  estimating  depreciation,  the  term  is  no  more  definite 
than  the  term  "cost  to  reproduce."  Fortunately  the  instructions  which 
the  valuation  engineer  receives  are  quite  usually  specific  with  respect  to 
the  use  by  him  either  by  the  straight  line  depreciation  method,  or  the 
sinking  fund  depreciation  method.  Volumes  upon  volumes  of  discussion 
on  the  merits  of  these  two  methods  might  be  cited.  There  was  a  time 
when  the  straight  line  method  was  much  in  favor.  We  believe  that  the 
time  will  come  when  it  will  be  used  but  rarely.  We  have  prepared  quite 
recently  a  lengthy  article  on  the  fundamental  conceptions  involved  iu  the 
two  methods,  and  have  been  urged  by  so  many  public  utility  men  and 
others  to  have  the  thesis  published,  that  you  may  possibly  find  it  in  one 
of  the  next  issues  of  Engineering  and  Contracting.  The  former  or 
straight  line  method  is  clearly  a  method  for  retiring  the  investment  year 
by  year,  and  if  in  a  rate  case  a  depreciation  allowance  is  granted  the 
utility  on  the  straight  line  basis  then  the  interest  return  on  the  invested 
principal  must  decrease  year  by  year  as  this  invested  principal  is  retired. 


9 

If  on  the  other  hand  the  rates  accorded  the  utility  include  an  allowance 
for  depreciation  which  is  based  on  the  sinking  fund  method  then  there 
is  no  retirement  year  by  year  of  the  capital  invested  and  the  interest 
return  on  the  investment  remains  a  constant,  year  by  year.  Inasmuch  as 
the  straight  line  method  is  a  re-payment  year  by  year  to  compensate  for 
the  wearing  out  of  the  property  and  does  not  involve  any  interest  rate 
of  money,  then  if  we  take  a  property  which  cost  $100,  which  will  have  to 
be  replaced  in  twenty-five  years  and  whose  salvage  value  at  the  time  of 
replacement  is  zero,  it  will  be  seen  that  the  necessary  annual  depreciation 
allowance  on  straight  line  basis  is  i^-,  of  $100.00  or  $4.00.  By  the  sinking 
fund  method,  we  do  not  re-pay  the  principal  year  by  year  in  annual  in- 
stallments, but  make  such  allowance  as  will,  during  the  life  of  the  prop- 
erty, compound  to  a  sum  equal  to  the  cost  of  the  property  whose  integritj' 
is  being  guaranteed  by  this  depreciation  fund.  Thus  instead  of  paying 
$4.00  annually  in  the  case  cited  above,  we  need  to  pay  but  $1.82.  This 
seems  to  be  advantageous  to  the  rate  payer,  but  it  is  so  only  in  the  earlier 
years.  Thus  if  we  add  together  the  straight  line  depreciation  and  the 
interest  return  on  the  diminishing  principal  for  one  curve  and  add  to- 
gether the  sinking  fund  depreciation  and  a  constant  interest  return  on 
the  original  investment  for  another  curve,  and  allow  these  two  amounts 
to  vary  as  ordinates  with  time  as  an  abscissa,  we  obtain  two  curves 
which,  with  the  average  utility,  come  to  an  intersection  at  from  five  to 
fifteen  years  after  the  inception  of  the  utility.  Before  this  intersection 
the  straight  line  method  demands  higher  rates  than  the  sinking  fund 
method;  after  this  intersection,  the  reverse  is  true. 

Thus  far  we  have  covered  in  a  very  brief  and  general  manner  that 
portion  of  the  valuation  report  which  includes  the  inventory,  the  unit 
prices  and  the  three  columns  of  cost  which  are  usually  demanded  in  such 
a  report.  We  have  already  indicated  that  in  addition  to  the  property 
which  can  be  inventoried  as  tangible  property  and  identified  and  counted 
in  the  field,  there  are  two  other  classes  of  property  which  come  into  the 
total  plant  which  are  not  susceptible  of  such  treatment.  One  of  these 
is  the  so-called  overhead  expenditures  which  are  classed  as  tangible  capi- 
tal and  which  involve  allowances  for  engineering,  law,  etc.  These  ex- 
penditures might  be  distributed  during  construction  days  to  those  ac- 
counts in  connection  with  which  they  would  be  incurred.  Such  distribu- 
tion, however,  would  frequently  be  arbitrary  and  but  little  good  would 
be  accomplished  by  it.  Consequently  these  expenditures,  though  many 
of  them  are  incurred  directly  in  connection  with  property,  are  neverthe- 
less best  carried  as  undistributed  construction  expenses  and  charged  to 
Account  C-35.  Hardly  a  single  valuation  report  has  ever  passed  the 
scrutiny  of  any  tribunal  without  the  introduction  of  testimony  as  to  the 
proper  allowance  for  these  so-called  overheads.    In  the  last  big  valuation 


10 

report  which  tlie  writer  has  prepared,  aiul  by  the  way  your  own  J'rofessor 
Cory  here  prepared  the  company's  inventory  and  appraisal,  we  were  very 
fortunate  in  being  able  to  obtain  a  so-called  "actual  performance"  under 
operating  conditions  which  might,  nevertheless,  yet  be  applicable  to  the 
construction  conditions  in  connection  with  which  these  derived  percent- 
ages were  used.  The  average  utility  which  is  in  operation  as  a  going  con- 
cern is  generally  interested  at  the  same  time  in  increasing  its  plant  by 
new  units  of  construction.  The  expenses  of  the  general  office  which  in- 
cludes most  of  the  overheads  are  then,  as  a  matter  of  conservative  ac- 
counting, charged  entirely  to  that  primary  sub-account  under  operating 
expenses  which  is  classed  as  ' '  General  and  Miscellaneous  Expenses. ' '  If 
we  assume,  and  this  must  frequently  be  done,  that  it  costs  as  much  to 
administer  $1,000,000  of  expenditures  in  the  way  of  operating  expenses, 
as  it  does  to  administer  $1,000,000  in  the  w^ay  of  construction  expendi- 
tures, then  it  becomes  possible,  where  the  books  are  carefully  kept,  to 
set  up  a  fraction  from  which  we  can  develop  a  satisfactory  '  *  actual  per- 
formance" percentage  for  overhead  expenditures.  This  fraction  will 
have  for  its  denominator  the  sum  of  charges  to  fixed  capital  Accounts 
C-5  to  C-34,  representing  Landed  Capital,  Production,  Transmission  and 
Distribution  Capital,  and  General  Structures  and  Equipment  and  charges 
to  operating  expense  Accounts  E-1  to  E-54  covering  Production,  Trans- 
mission, Distribution  and  Commercial  Expenses.  The  numerator  will  in- 
clude all  charges  to  fixed  capital  Account  C-35,  Undistributed  Construc- 
tion Expenditures,  and  all  charges  to  operating  expense  Accounts  E-55 
to  E-77,  General  and  Miscellaneous  Expenses.  This  procedure  has  been 
worked  out  very  carefully  in  connection  with  several  recent  valuations  of 
gas  utilities  in  this  state  and  it  is  interesting  to  observe  the  remarkable 
agreement  in  total  percentages  applied  to  cover  overhead  in  the  gas  valu- 
ation already  referred  to  in  which  your  own  Professor  Cory  prepared  the 
valuation  from  the  utility's  point  of  view  and  the  writer  was  responsible 
for  the  work  done  in  the  engineering  department  of  the  California  Eail- 
road  Commission.  There  was  also  a  third  valuation  engineer  involved  in 
this  ease,  representing  the  city  within  which  this  utility  operates.  If  we 
lump  together  those  overheads  which  are  chargeable  to  engineering,  super- 
vision, law,  injuries  to  persons,  taxes,  administration,  fire  insurance, 
transit  insurance,  casualty  insurance  and  tool  expense,  we  find  that  the 
city  used  a  flat  figure  of  10  per  cent  of  the  base  prices  for  the  entire 
plant  excluding  real  estate,  services  paid  for  by  consumers  and  paving. 
On  the  same  basis,  the  writer  obtained,  after  a  very  thorough  investiga- 
tion, account  by  account,  a  total  of  10.60  per  cent;  while  the  engineer  for 
the  utility,  who  prepared  two  different  valuations  on  two  different  bases 
or  theories,  showed  an  average  percentage  of  these  tw^o  values  amounting 
to  very  slightly  over  11  per  cent.     We  believe  that  in  the  future  over- 


11 

head  percentages  can  be  worked  out  along  these  lines  in  such  a  manner 
that  they  will  not  in  every  instance  be  a  cause  of  argument  and  dispute. 

In  order  to  complete  the  valuation  of  a  gas  plant  it  is  yet  necessary 
to  make  adequate  allowance  for  the  four  intangible  capital  accounts,  C-1 
to  C-4,  including  Organization,  Franchises,  Patent  Rights,  and  Other  In- 
tangible Capital. 

The  next  step  in  order  to  wind  up  the  valuation  is  to  make  adequate 
allowance  for  contingencies,  errors  in  computation  and  inventory  omis- 
sions. One  might  think  that  errors  in  computation  woulil  balance  each 
other,  nevertheless  experience  seems  to  demonstrate  that  if  any  error 
occurs  and  gets  past  the  checker  it  is  frequently  an  error  of  the  decimal 
where  the  amount  shown  is  one-tenth  of  the  proper  product  rather  than 
ten  times  the  proper  product.  It  is  easy  to  see  why  the  latter  class  of 
error  stands  out  prominently,  while  the  former  may  be  overlooked. 

This  completes  the  valuation  report  as  far  as  the  inventory  and  ap- 
praisal of  the  plant  is  concerned.  In  a  rate  case  it  will  be  necessary  in 
addition,  in  order  to  develope  a  figure  which  will  serve  as  a  rate-base,  to 
consider  working  capital,  which  includes  the  stores  and  supplies  of  Asset 
Account  No.  9,  aud  the  working  cash  capital  which  necessarily  must  be 
tied  up  by  a  going  concern.  This  leaves  one  more  important  item  to  be 
considered,  namely  Development  Cost,  and  this  frequently  has  been  han- 
dled to  advantage  by  the  Accounting  Department. 

After  the  report  is  complete  it  will  serve  as  a  basis  or  starting  point 
for  conclusions  as  to  transfer  price  in  case  of  sale  or  condemnation  pro- 
ceedings, to  tax-base  for  taxation,  to  rate-base  for  rate  cases,  and  to 
security  in  case  of  the  assumption  of  additional  funded  or  unfunded 
financial  obligations.  The  steps  which  are  necessary  before  the  valuation 
can  be  put  into  shape  for  use  in  connection  with  proceedings  of  any  of 
these  classes  is  quite  a  large  subject  by  itself,  and  cannot  be  gone  into 
here. 

In  closing  it  might  be  well  to  emphasize  the  fact  that  this  paper  as  a 
whole  may  properly  be  considered  as  a  syllabus  only  of  the  subject  which 
it  purports  to  cover  in  a  general  way. 

If  the  general  considerations  which  have  been  outlined  here  in  such 
a  very  cursory  and  general  manner  have  given  you  gentlemen  something 
to  think  about  and  discuss  with  each  other  and  with  your  instructors,  the 
purpose  of  this  paper  will  have  been  achieved. 


207108 


UNIVERSITY  of  CALIFORNIA 


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